ANTI-INSURANCE ROBERT COOTER and ARIEL PORAT* ABSTRACT In standard models of contracts, efficient incentives require the promisor to pay damages for nonperformance and the promisee to receive no damages. To give efficient incentives to both parties, we propose a novel contract requiring the promisor to pay damages for nonperformance to a third party, not to the promisee. In exchange for the right to damages, the third party pays the promisor and promisee before performance or nonperformance occurs. We call this novel contract "anti-insurance" because it strengthens incentives by magnifying risk, whereas insurance erodes in- centives by spreading risk. Anti-insurance is based on the general principle that when several parties jointly create risk, efficient incentives typically require each party to bear the full risk. Without a third party, the most that can be achieved is to divide the risk among the parties. By improving incentives, anti-insurance contracts can create value and benefit everyone as required for a voluntary exchange. PROMISES pose a dilemma for incentives. For unenforceable promises, con- tract law does not require the promisor to pay damages for nonperformance. Without liability, the promisor has an incentive to exert too little effort to perform. For enforceable promises, contract law requires the promisor to pay damages for nonperformance to the promisee. With damages, the promisee has an incentive to rely too much and to assist the promisor too little. Liability for less than 100 percent of the harm caused by nonperformance erodes the * Herman F. Selvin Professor of Law and Director of the John Olin Program in Law and Economics, University of California at Berkeley; and Professor of Law and Dean, the Faculty of Law, Tel Aviv University, respectively. For useful comments on a previous draft of the paper, we wish to thank Mat Adler, Jennifer Arlen, Danny Ben-Shahar, Omri Ben-Shahar, Hanoch Dagan, Daniel Friedmann, Zohar Goshen, Eugene Kandel, Tsachi Keren-Paz, Roy Kreitner, Kyle Logue, Ronald Mann, Menny Mautner, Eric Posner, an anonymous reviewer, the participants in the law and economics workshops at University of California at Berkeley, University of Chicago, Hamburg University, University of Michigan, New York University, University of Toronto, and Yale University, the participants in the faculty workshop at the Hebrew University of Jerusalem, Interdisciplinary Center in Herzlya, Rationality Center in Jerusalem, Tel Aviv University, and the participants in the 2001 annual meeting of the American Law and Economics Association. For fruitful discussions, we wish to thank Lucian Bebchuck, Lisa Bernstein, Udi Dekel, Melvin Eisenberg, Avigdor Klagsbald, Saul Levmore, Barak Medina, Roger Noll, Ariel Rubinstein, and Stephen Sugerman. Our special thanks to Omri Yadlin. [Journal of Legal Studies, vol. XXXI (June 2002)] © 2002 by The University of Chicago. All rights reserved. 0047-2530/2002/3102-0001$01.50 HeinOnline -- 31 J. Legal Stud. 203 2002 THE JOURNAL OF LEGAL STUDIES promisor's incentives, and liability for more than 0 percent erodes the prom- isee's incentives.' This dilemma can defeat exchange, as in the following example: Example 1: Warrantyfor the Transmission on a Used Car. Seller un- dertakes to repair the manual transmission of a used car before selling it to Buyer. Buyer fears that Seller will not supply a good transmission unless compelled by a warranty. So Buyer asks Seller to promise that the trans- mission will work for 1 year. Transmission failure within 1 year would breach the contract and cause Seller to pay damages. However, Seller fears that Buyer might abuse a warranted transmission, so Seller offers a warranty for only 3 months. To allay Seller's fears, Buyer proposes that his abuse of the transmission should void the warranty. Seller rejects this proposal because he could not prove Buyer's abuse in court. The parties stop negotiating, and no sale occurs. Buyer cannot observe the quality of the transmission that Seller installs, and Seller cannot observe Buyer's care in using the transmission. Unob- servable acts affecting a risk defeat a bargain in this example. When several actors affect a risk, efficient incentives require each of them to bear the full risk. Specifically, when the promisor and promisee affect the probability of nonperformance or the magnitude of the resulting loss, efficient incentives require each of them to bear 100 percent of the resulting harm. The standard devices of contract law do not produce this result and cannot provide efficient incentives to both parties. To solve this dilemma, we propose a novel contract requiring the promisor to pay damages to a third party, instead of the promisee, in the event of nonperformance.2 Liability to the third party gives the promisor efficient incentives to perform. Receiving no damages gives the promisee efficient incentives to restrain reliance and assist performance.3 In exchange for the right to damages, the third party pays the others in advance before performance or nonperformance occurs. ' Robert Cooter, Unity in Tort, Contract, and Property: The Model of Precaution, 73 Cal. L. Rev. 1, 3-4 (1985), 2 For a contract allowing a third party to collect damages in case of a breach, see St. Joseph's Association v. Magnier, 16 La. Ann. 338 (1861). In that case, hatters agreed to close stores on Sunday and stipulated that any hatter violating the agreement should pay a fine of $100 to the asylum of the St. Joseph's Orphans. The asylum brought a suit against the defendant to recover the stipulated fine, arguing that he opened his store on several Sundays. The court dismissed the suit, saying, "It is a strained and unnatural construction to say that the contract was entered into with the view of making a donation to the plaintiffs." (We thank Melvin Eisenberg for this example.) In the diamond industry, arbitrators may sometimes impose sanc- tions on the party in breach involving not only compensation to the aggrieved party but also a donation to charity. Lisa Bernstein, Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry, 21 J. Legal Stud. 115, 134-35 (1992). For a suggestion that under certain circumstances large liquidated damages would be paid to a third party instead of the aggrieved party, see Charles R. Knoeber, An Alternative Mechanism to Assure Con- tractual Reliability, 12 J. Legal Stud. 333 (1983). 3 Sometimes nonlegal sanctions create the same incentives. See Robert Cooter & Ariel Porat, Should Courts Deduct Nonlegal Sanctions from Damages? 30 J. Legal Stud. 401 (2001); Ariel HeinOnline -- 31 J. Legal Stud. 204 2002 ANTI-INSURANCE We illustrate this novel contract, which we call "anti-insurance," by ap- plication to example 1. Assume that Third Party purchases Buyer's right to damages from Seller for transmission failure. Third Party pays in advance for this assignment of the liability right, before anyone knows whether or not the transmission will fail. If the transmission fails, Seller must pay dam- ages to Third Party, and this fact gives Buyer confidence that Seller will supply a good transmission. If the transmission fails, Buyer will not receive any compensation, and this fact gives Seller confidence that Buyer will not abuse the transmission. By improving incentives, anti-insurance increases the value of the underlying transaction. Later we provide a numerical example in which anti-insurance benefits all three parties. In the usual insurance contract, the insurer assumes the insured's risk, thus eroding the insured's incentives to reduce the risk. For example, when an insurance company assumes the car owner's risk of theft, the owner has less incentive to prevent theft. Anti-insurance inverts the usual insurance contract. In an anti-insurance contract, the anti-insurer increases the anti-insured's risk, thus strengthening the anti-insured's incentive to reduce the risk. To illustrate, anti-insurance increases the promisee's risk of loss from the promisor's non- performance. In general, insurance erodes incentives by spreading risk, and anti-insurance strengthens incentives by magnifying risk. By imposing the full cost of a risk on everyone who affects it, anti-insurance causes everyone to internalize the risk, which produces efficient incentives. Anti-insurance indirectly controls the acts that affect a risk by internalizing its cost. An alternative approach directly controls the acts that affect a risk. To illustrate direct control in example 1, Buyer could promise to keep the gears lubricated, not to shift gears roughly, not to accelerate too fast, and so on. Seller, however, cannot observe and verify Buyer's performance of these promises. In contrast, the anti-insurer can probably observe and verify trans- mission failure relatively easily. Consequently, anti-insurance in example 1 faces fewer practical obstacles than direct controls. In general, internalizing a joint risk often has lower transaction costs than contracting to control all 4 the acts that significantly affect it. Section I use a numerical example to illustrate anti-insurance. Section II explains some general propositions proved in the Mathematical Appendix. Section III discusses the factors determining the scope of anti-insurance. Section IV provides more examples. Section V extends the application of anti-insurance from risky losses to risky gains, and Section VI explains how to recast anti-insurance for losses into anti-insurance for gains, or vice versa. Section VII discusses the advantages of anti-insurance over other legal de- vices. In Section VIII, we will speculate on some possible applications of Porat, Enforcing Contracts in Dysfunctional Legal Systems: The Close Relationship between Public and Private Orders, 98 Mich. L. Rev. 2459 (2000). 4 Robert Cooter, Prices and Sanctions, 84 Colum. L. Rev. 1523 (1984). HeinOnline -- 31 J. Legal Stud. 205 2002 THE JOURNAL OF LEGAL STUDIES FIGURE 1.-Assistance and performance anti-insurance. The conclusion poses the question, Why are there currently no anti-insurance markets? I.